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These bond funds and ETF types could make money in 2014

After the worst year for U.S. bonds in two decades, two categories stand out

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RachelKoning Beals

RachelKoning Beals

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CHICAGO (MarketWatch) — The death of a decades-strong bond bull market may be exaggerated, but fixed-income investors aren’t waiting to find out.

Buyers abandoned U.S. fixed income mutual funds and exchange-traded funds in 2013, most heading for stocks, in a record outflow from bond funds spurred by the Federal Reserve plans to “taper” its economy-supporting bond buying.

Bond bargains for 2014

(4:07)

Barron's fixed income specialist Michael Aneiro talks with Jack Hough about where to find healthy, safe yields in 2014.

Investors fled bond funds in 2013. The strongest exodus kicked in from June on, following Fed Chairman Ben Bernanke’s late-May congressional testimony that intensified talk of the Fed cutting back on its bond buying, a device it used to hold down long-term interest rates and juice economic growth.

Notably, an estimated $41 billion was pulled from giant Pimco Total Return Fund
PTTAX, +0.09%
, according to data from investment researcher Morningstar Inc. The mutual fund run by bond guru Bill Gross lost 1.9% for the year, while a sibling exchange-traded fund
BOND, +0.24%
Pimco Total Return ETF, saw $197 million go out the door in 2013 and finished the year down 1.3%.

Bond prices slumped, even after the Fed in December officially announced it would begin to taper. Most every major, traditional U.S. bond-fund category lost value on average in 2013, according to preliminary Morningstar data, in the worst showing for bonds since 1994.

For investors who had shunned stocks for the perceived safety of bonds over the past few years, 2013 was particularly painful. The Barclays U.S. Aggregate Bond Index, a measure of the broad bond market, declined 2% in 2013, while the S&P 500
SPX, -0.88%
, a benchmark for U.S. stocks, gained 32.4%, including dividends.

Still, investors in high-yield and other riskier areas of the bond market enjoyed respectable returns compared to other bond classes.

For 2014, strategists say high-yield again looks poised to outperform, joined by select municipal bond funds.

Record 2013 outflows top the previous record from 1994, when bond-fund investors withdrew almost $63 billion. That year, the 10-year Treasury yield rose above 8% from just under 6%. In late 2013, the yield on the 10-year
US:10_YEAR
a benchmark for most borrowing costs, topped the psychologically significant 3% mark for the first time since September, leaving many to wonder how quickly and how much higher it can go.

Yet some of that move has been steadily absorbed by the bond market.

“A better U.S. growth picture, post-taper, is priced in to the market,” said Robert Tipp, chief investment strategist at Prudential Fixed Income. After all, 10-year U.S. government bond rates at 3% are higher than those around the developed world.

“At the same time, the Fed is pretty committed to keep [its short-term interest rate tool] the fed funds rate at or around zero for at least a year, if not two,” Tipp says. “The attraction of higher yields [which accompany lower prices] and the reality of a Fed on hold will bring stability to long-term fixed income through the first half of next year.”

Best of the bunch

High-yield bonds were snared in the springtime price drop (and yield spike) seen across the bond sector. The broader bond market remained weak, but high yield, which is more likely to track stock market movements, recovered and gained without pause for the rest of 2013.

Leading the fixed-income fund category, high-yield bond funds gained 3.2% on average in the fourth quarter and 6.9% for the year, Morningstar reports. The year’s best-performing high-yield fund was Fairholme Focused Income Fund
FOCIX, +0.09%
which gained 30% and topped its closest rival, Third Avenue Focused Credit Investor Fund
TFCVX, -0.11%
by 13 percentage points.

Bank-loan funds also turned in a strong 2013, gaining 1.8% in the quarter and 5.6% on the year. The category standout: Highland Floating Rate Opportunities Fund
HFRAX, +0.00%
, up 17% on the year.

Meanwhile, funds holding corporate bonds with higher credit ratings finished the quarter up 1.3%, but lost 1.1% in 2013.

High-yield, also known as junk bonds, has performed in an environment “where the U.S. economy is improving, unemployment is down, there’s a [federal] budget accord, and Europe is calmer,” said Sabur Moini, manager of Payden High Income Fund
PYHWX, +0.00%
, which gained 4% in 2013.

High-yield bond funds tend to have lower duration than their government- bond peers, which means they’re less vulnerable to the interest-rate fluctuations that have most bond investors running for cover, Moini points out. Plus, high yields, though they pack higher risk, tend to cushion funds from price and interest-rate changes.

Importantly, company default rates are low and expected to stay that way, as low interest rates have allowed below-investment-grade companies to refinance at more attractive levels and with better repayment terms.

Moini compares the average yield of his fund’s holdings to that of a five-year Treasury, which ranged roughly between 1.4% and 1.7% in December. With the portfolio’s high-yield bonds yielding 6% on average, that four-to-4.5 percentage-point spread over a lower-risk government issue is “pretty attractive” historically, he says. He expects the benchmark 10-year yield at 3.25% to 3.5% in 2014, which means a “rate environment that’s not hostile to high yield.”

Among 2013’s hardest-hit bond-fund groups, long-dated government bond funds fell 3.7% in the final quarter and lost 13.3% for the year. Funds that hold Treasury Inflation-Protected Securities, or TIPS, shed 1.7% in the quarter and 7.9% for the year.

Short-dated government bond funds fared better, being less sensitive to interest-rate changes, finishing the quarter up 0.3% and rising 0.5% for the year. Emerging-market bond funds were flat in the quarter and lost 7.3% during 2013. World bond funds, which hold securities in developed markets, ended the quarter up half a percentage point, but lost 2.6% in 2013.

By comparison, most U.S. stock funds logged roughly 30%-40% annualized returns on average in 2013, according to Morningstar. And stock-fund inflows last year were the strongest in a decade that has largely favored bond funds, according to TrimTabs.

Muni bargains

In the tax-exempt space, long-term national municipal bond funds ended the year’s final quarter flat and lost 4.6% in 2013. Short-dated national funds edged up 0.3% in the quarter, and were basically unchanged for the year. High-yield muni funds scratched out a 0.1% fourth-quarter gain, but dropped 6% in 2013.

For some fund managers, those weak results present a buying opportunity.

High-profile credit nightmares in Detroit and Puerto Rico make for rousing headlines, but they do not characterize the broader municipal market, says Jeffrey Rosenberg, chief investment strategist for fixed income at BlackRock.

“Those stories changed the perception of risk, and valuations have adjusted,” he said.

Policy and politics

Across the fixed income space, limiting exposure to interest-rate fluctuations over time, known as duration in market parlance, could be critical in successfully navigating the Fed’s policy decisions.

“The Fed will … put less emphasis on its bond buying and instead focus on its forward guidance in hope that it can convince investors that there will be plenty of presents under the tree for quite a long time, with the policy rate staying at zero probably until at least 2016,” says Tony Crescenzi, market strategist and portfolio manager at bond-fund giant PIMCO, in an outlook posted on his firm’s website in December. Firm records show PIMCO sold longer-dated bonds in favor of shorter maturities in November.

“This, along with the [Fed’s] strong determination to boost inflation, is a reason for bond investors to stay focused on short and intermediate maturities and to avoid maturities beyond 10 years, where the Fed’s bond buying has had the most effect,” Crescenzi adds.

Shortening a bond portfolio’s duration, in fact, helps to keep an investor from fleeing the bond market at a weak point, and to maintain valuable diversification and income.

Says Prudential’s Tipp: “Fixed income investors who stay the course will do much better over the next three to five years than those who get out and have to get back in. They’ll have given up too much yield in the meantime.”

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